States are split on the issue. Four state courts have said “yes” and five have said “no”, North Carolina being among the no’s. In 2016, the NCDOR lost an appeal from an NC Superior Court decision holding that the state did not demonstrate the “minimum contacts” necessary to satisfy the principles of due process required to tax an out-of-state trust. Here’s how it all played out:
The original trust was established by Joseph Lee Rice III in New York. The primary beneficiaries of the trust were his descendants, none of whom lived in North Carolina at the time of the trust’s creation. In 2002, the original trust was divided into three separate trusts, one for each of Rice’s three children: Kimberly Rice Kaestner, Daniel Rice, and Lee Rice. At that time in 2002, Kimberley Rice Kaestner, the beneficiary of the Kimberley Rice Kaestner Family Trust (the trust in the current US Supreme Court case), was a resident and domiciliary of North Carolina. Tax returns were filed in North Carolina on behalf of the Kimberley trust for tax years 2005-2008 for income accumulated by the trust but not distributed to a North Carolina beneficiary.
In 2009, the trust filed a claim for a refund of taxes paid -- more than $1.3M. Representatives of the trust asserted that NCDOR’s contention that a beneficiary’s domicile alone is sufficient to satisfy the minimum contacts requirement conflates what the law recognizes as separate legal entities -- the trust and the beneficiary. The Court of Appeals of NC agreed. The fact that the beneficiary was in NC did not provide sufficient contact for the state to tax the trust. The connection between NC and the trust did not satisfy the requirements of due process.
It’s important to note that this SCOTUS case is about taxing trusts themselves (not trust companies and not beneficiaries). Trust income is taxable—either to the trust if the income stays in the trust as undistributed income, or to the beneficiaries if it’s distributed out to them. There’s no question that trust distributions to beneficiaries are taxable to the beneficiaries in whatever state they live in (unless they live in a no-state-income-tax state). What North Carolina DOR is trying to do is tax the out-of-state trust on its undistributed income, which is meant for the beneficiary eventually.
So, why is the upcoming SCOTUS case such a big deal? Two reasons:
One, it’s a huge financial impact on states. If NC wins, some states will be able to tax income they could not tax before. On the flip side, if the Supreme Court affirms the decision in favor of the trust, taxpayers in states such as California will be entitled to potentially huge refunds. It’s a really big deal. North Carolina alone has already received more than 450 contingent income-tax returns from trusts awaiting the outcome of the case.
Second, the income tax consequences to families are at stake. Nearly every state taxes trust income, and 11 states, including North Carolina and Minnesota, tax trusts based on trust beneficiaries' in-state residency. Wealthy families can keep their money growing in trusts sometimes for more than 100 years, so the income-tax consequences here are huge.
We’ll keep our eye on this one. The SCOTUS case is set for argument on April 16, 2019.
